TOPIC 22

Consumer choice

THEORY OF CONSUMER CHOICE

• Analyses how consumers make their choices.

• Enables us to answer Why do demand curves

slope downwards?

• Basic idea
– Consumers do the best they can for themselves
with their limited income.
– The idea of doing ‘the best they can’ involves
representing their preferences & selecting
consumption choices which best fulfil these
preferences.

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 BUDGET CONSTRAINT
• Budget constraint represents the limit on the
consumption bundles that a consumer can afford.
– People consume less than they desire because their
spending is limited by their income.

• The budget constraint shows the combinations of

goods the consumer can afford given her income
& the prices of goods.
– Consider a simple case - just 2 goods – Pepsi &
pizzas.
– Suppose pizza costs $10, Pepsi costs $2 and the
consumer has $1000 to spend each week.

BUDGET CONSTRAINT

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 BUDGET CONSTRAINT
• The budget constraint graphs the consumption
bundles that the consumer can choose.
– At point A, the consumer buys no Pepsi and
consumes 100 pizzas.
– At point B, the consumer buys no pizzas and
consumes 500 Pepsis.
– All the combinations of pizzas and Pepsi on or
below the budget constraint are affordable.
– Any combination above/outside the constraint are
not affordable given the income of the consumer
and the prices of goods.

BUDGET CONSTRAINT
Quantity
of Pepsi
B
500

Budget
line

Budget
set
A
0 100 Quantity
of pizzas

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 BUDGET CONSTRAINT
• The slope of the budget line measures the rate
at which one good can be traded for the other.
– the relative price of one good in terms of the other.

• For our example

– the y-intercept is 500 Pepsis and the x-intercept is
100 pizzas.
– Thus, the slope is 5 (Pepsis per pizza).
– This is also the ratio of price of pizza to price of
Pepsi ($10/$2 = 5).

BUDGET CONSTRAINT
• Alternatively the slope measures the rate at
which consumer must substitute one good for
the other keeping him within budget given the
prices
– the objective rate of substitution between goods in
the market.

• If income increases
– Both intercepts change.
– The budget constraint shifts outwards.
• With a higher income, the consumer can afford more of
both goods.

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 BUDGET CONSTRAINT
• Key Point
– Relative prices determine slope of budget line.
– Income determines its position.
Quantity Quantity
of Pepsi of Pepsi

0 Quantity 0 Quantity
of pizzas of pizzas

CONSUMER PREFERENCES
• Consumers’ choices depend both on
– what they can afford (their budget sets) and
– their preferences for certain goods.

• If different bundles are affordable, a consumer

chooses the bundle to best suit her preferences.

• If different bundles suit a consumer’s preferences

equally well, we say that the consumer is
indifferent between these bundles.

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 INDIFFERENCE CURVES
• An indifference curve shows the consumption
bundles that make a consumer equally happy.
– Gives the consumer the same satisfaction

• A consumer’s preference/indifference among

consumption bundles may be illustrated with
indifference curves.
– The consumer is indifferent among combinations A,
B and C, because they are all on the same curve.

INDIFFERENCE CURVES
Quantity
of Pepsi
C

B D
I2
Indifference
A
curve, I1
0 Quantity
of pizzas

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MARGINAL RATE OF SUBSTITUTION

• The slope at any point on an indifference curve

indicates
– the rate at which a consumer is willing to substitute
one good for another to get the same satisfaction.
– Alternatively, it is the amount of one good the
consumer requires as compensation to give up one
unit of the other good.

• Called the marginal rate of substitution (MRS).

MARGINAL RATE OF SUBSTITUTION

• Thus, the slope of an indifference curve (MRS)
measures how much Pepsi the consumer
requires in order to be compensated for a one-
unit reduction in pizza consumption.
– In the following graph, (ignoring the sign) MRS is
0.5/1 = 0.5

• Because the indifference curves are not

straight lines, the MRS varies along an
indifference curve.

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 MARGINAL RATE OF SUBSTITUTION
Quantity
of Pepsi
C

B D
I2
MRS=0.5/ 0.5
1 =0.5 1 Indifference
A
curve, I1
0 Quantity
of pizzas

INDIFFERENCE CURVES – PROPERTIES

• Property 1: Since more consumption is preferred
to less, higher indifference curves are preferred
to lower ones.
– As higher IC’s represent larger quantities of goods
than do lower indifference curves.

• Any point on curve I2 (such as D) is preferred to

any point on curve I1 (such as A, B or C).

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INDIFFERENCE CURVES – PROPERTIES
Quantity
of Pepsi
C

B D
I2

A I1
0 Quantity
of pizzas

INDIFFERENCE CURVES – PROPERTIES

• Property 2: Indifference curves are downward-
sloping:
– If the quantity of one good is reduced, the quantity
of the other good must increase in order for the
consumer to be equally happy.
– In other words, a consumer is willing to give up one
good only if she gets more of the other good to
remain equally happy.

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INDIFFERENCE CURVES – PROPERTIES
• Property 3: Indifference curves do not cross.
– To see why this is true, suppose that two
indifference curves cross.
• Points A and B are on the same indifference curve
(I1)
– Consumer indifferent between A and B
• B and C are on the same indifference curve (I2).
– Consumer indifferent between B and C

– Transitivity suggests that the consumer is

indifferent between A and C
• This cannot be true as C has more of both goods.

INDIFFERENCE CURVES – PROPERTIES

Quantity
of Pepsi

B
I1

I2

0 Quantity of pizzas

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INDIFFERENCE CURVES – PROPERTIES
• Property 4: Indifference curves are bowed
inwards (they are convex).
– People are more willing to give up goods they have in
abundance and
– less willing to give up goods they have little of.
– At point A, the consumer has a lot of Pepsi and only a
little pizza, making her very hungry but not very thirsty.
• To induce her to give up one pizza, she has to be given 6
Pepsis.
– At point B, the consumer has little Pepsi and a lot of
pizza, and so is very thirsty but not very hungry.
• To induce her to give up one pizza now, she has to be given
just 1 Pepsi.

INDIFFERENCE CURVES – PROPERTIES

Quantity
of Pepsi

14

MRS = 6

A
8
1

4 B
MRS = 1
3
1
Indifference
curve
0 2 3 6 7 Quantity
of pizzas

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 TWO EXTREME EXAMPLES OF
INDIFFERENCE CURVES

CONSUMER’S OPTIMUM CHOICE

• A consumer wants to get the combination of
goods on the highest possible indifference
curve.

• However, the consumer must also remain on or

below her budget constraint.

• Thus consumers optimise subject to a budget.

– This is the basic model of how consumers choose.

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 CONSUMER’S OPTIMUM CHOICE
• Thus the consumer’s optimum choice is
determined by combining
– the indifference curves (preferences) and
– the budget constraint.

• The consumer optimum occurs where the

highest indifference curve & the budget
constraint are tangent.
– One of the most basic and important results in
economics.

CONSUMER’S OPTIMUM CHOICE

Quantity
of Pepsi

Optimum

B
A

I3
I2
I1
Budget constraint
0 Quantity
of pizzas

13
 CONSUMER’S OPTIMUM CHOICE
• At this optimum, the slope of the indifference
curve (MRS) equals the slope of the budget
line (the relative price).
MRS = Ppizza/PPepsi

• At the consumer’s optimum, consumer’s

subjective valuation of the two goods equals
market’s objective valuation.
– Also called the tangency condition.

SUMMARY
• A consumer’s budget constraint shows the
possible combinations of different goods he
can buy given income & the prices of goods.

• The slope of the budget constraint equals the

relative price of goods.

• The consumer’s indifference curves represent

his preferences.

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 SUMMARY
• Points on higher IC’s are preferred to points on
lower IC’s .

• The slope of an IC at any point is the

consumer’s marginal rate of substitution.

• A consumer optimises by choosing the point on

the budget constraint lying on highest IC.

• This is the tangency condition of consumer

theory.

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